Calling on-demand performance bonds – every word counts

A recent decision by the highest court in Queensland, Australia, serves as a good reminder that when seeking to make a call on a performance bond or bank guarantee, there must be strict adherence to its terms – otherwise, the issuer may be entitled to ignore the demand. This alert looks at recent Australian and English cases and the importance of strict compliance when it comes to calls on performance bonds.

The purpose of on-demand performance bonds is to provide a quick self-help remedy without having to prove that a default has in fact occurred. For this reason, the courts have consistently taken the view that the requirements of such bonds must be complied with strictly before the issuing bank or financial institution is required to make a payment.

This approach was confirmed in the recent case of Santos Limited v. BNP Paribas,1 which centered on the following:

BNP Paribas refused to meet the demand, arguing that it was defective in that, among other things, it did not purport to have been signed by an authorised representative of Santos.

The Queensland Court of Appeal agreed that Santos’ demand was invalid on the basis that the demand for payment had to meet the essential elements set out in the draft letter – and one of those elements was the inclusion of a statement as to the signatory’s authority. The Court of Appeal found that a signature accompanied by a description of that person’s role in the company was not sufficient in this respect and BNP Paribas therefore did not have to pay out the sum demanded by Santos.

Previous cases in Australia have followed the same approach. In Simic v. NSW Land and Housing Corp,2 Australia’s highest court confirmed that strict compliance with the requirements of a bond is necessary. In this case, the performance bond mistakenly referred to “New South Wales Land & Housing Department trading as Housing NSW” (a body that did not exist). When NSW Land and Housing Corp made a demand under the performance bond and referred to its actual name, the bank refused to make a payment.

The court held that the bank’s refusal to accept the demand was justified because the bank would not be able to determine that the entity named in the demand was the same as the entity named in the performance bond. The court did, however, rectify the wording of the performance bond to reflect the correct name, so that NSW Land and Housing Corp could make a subsequent valid demand.

These decisions may seem harsh at first; however, there are sound reasons for ensuring strict compliance with the terms of security documents. It must be remembered that the issuing banks or financial institutions are not privy to the circumstances of the underlying contract and are unable to investigate the circumstances giving rise to the demand – all they can do before paying out potentially significant sums which they may not be able to recover, is to ensure that the demand received complies with the provisions of the bond.

English law approach

The decisions of Australian courts are consistent with English law, which also calls for strict compliance when it comes to calls on performance securities.

In Frans Maas (UK) v. Habib Bank AG Zurich,3 the English High Court held that a demand under a performance bond was invalid because it did not refer to a failure to pay. The provisions of the performance bond (issued on behalf of a clothing company, Palmier) required that any demand be in writing “stating therein that [Palmier] have failed to pay you under their contractual obligations”. However, the demand stated that Palmier has “failed to meet their contractual obligations to us” without any reference to a failure to pay. The court held this to be insufficient, as without further investigation the bank would not be able to determine whether a failure to pay occurred.

Similarly, in Maritza v. Crédit Agricole,4 the High Court held that a demand under a performance bond was invalid because it did not include notices and invoices that reflected the sum claimed. When calling on the bond, Maritza had to include “any notice to or claim against Contractor relating to the respective breach of its obligations to which the demand refers”. Maritza’s demand under the performance bond was for payment of €93 million, but the enclosed supporting notices amounted only to €27 million. The court did not consider this to meet the requirements of the performance bond because the demand did not attach any notice or claim for the balance of about €66 million.

In Sea Cargo Skips v. State Bank of India,5 a US$15 million bond required that any demand must state that there was a delay in “the construction of the vessel for more than 270 days as set out in the contract article IV 1(e), which entitles the buyer to cancel the shipbuilding contract and receive repayment of the advance payments” and that the shipbuilding contract had been cancelled. Sea Cargo’s demand, however, stated that: “We confirm that the vessel has not been delivered by the delivery date of 30 June 2011 or within 270 days of the same, that is by 26 March 2012 and that the Buyer has accordingly exercised their right to cancel the Contract.” This call was held to be invalid because:

It referred to a delay in delivery, instead of delay in construction.

It did not refer to article IV 1(e) of the contract.

It did not state that Sea Cargo was entitled to receive repayment.

Concluding remarks

On-demand performance bonds are designed to be ‘as good as cash’, providing a quick self-help remedy for default. The only requirements that must be met to receive payment are those set out in the performance bond itself and there is no sympathy from the courts for a failure to adhere to these requirements. This has long been the position taken by the courts in a number of jurisdictions, and has now been reiterated in the Santos case.

In their decisions, the courts have repeatedly acknowledged that the issuing banks or financial institutions do not have sufficient information about the underlying contract or circumstances to determine whether they should make a payment. Insisting on strict compliance with the provisions of the bond is therefore the only protection that could be afforded to them.

For these reasons, a demand should always be drafted exactly according to the terms of the performance bond, even if those requirements may appear to be unnecessary or contain an error. Ideally, the demand should be carefully reviewed and checked by counsel before it is issued.

While it may be possible to cure a defective demand by simply issuing a new and compliant one (as occurred in the Maritza or Simic cases), relying on this presents a number of risks. If the call is made close to the expiry date of the performance bond (which is frequently the case), time may have run out before a second valid demand can be made. Also, in the period after the first demand but before any subsequent demand is made, the contractor (or other company for whom the bond was issued) may learn that a call has been made and seek an injunction to prevent a pay-out. While applications for such an injunction are often not successful, the process can nevertheless be disruptive and delay any payment under the performance bond (a situation that the on-demand performance bond is designed to avoid).

It is therefore always best to ensure that the first demand is fully compliant with the terms of the security document. As Santos learned recently, the consequences of non-compliance may be substantial, albeit easily avoided.